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Capital Drilling - Drilling through Headwinds

I covered Mining support services group, Capital Drilling (LSE:CAPD) back in March when I stated the following: "There is little doubt that an investment in Capital Drilling would signal two things. Firstly you would have to be confident in a successful outcome at Sukari (this would create an upside catalyst) and secondly, you would have to be cautiously optimistic on the state of the mining industry towards the end of 2013. Personally, I believe that an outcome at Sukari is likely to be positive for the company, but I remain sceptical about the mining sector as a whole." Consequently, I set a target price of 30p which was in excess of 7p worth of downside at the time. Following a continued downturn in the mining industry, Capital Drilling exceeded my target within a short period of time. However, having kept up to date with the company's corporate updates, I have been distinctly impressed by the decisions taken by management and Interim CEO Jamie Boyton. I now reckon that Capital Drilling (abbreviated CapDrill) is a decent indirect way to follow any upturns in the mining industry without taking on the cash risks associated with smaller miners.

Having overshot my 30p target price, CapDrill's current price is 19.875p meaning that is has a market capitalisation of £26.75m. Upon the release of the IMS this morning, as outlined in the chart, CapDrill signalled a very bullish sign, as the share price backtested 17.5p and then shot straight back up in short order which proves there is buying support. It's even more positive in that the share price ended up on the day, and looks set to retest 20p after a couple of weeks of no price movement. The indicators are not useful considering the illiquidity, but overall, with the possibility of a double bottom, the technical picture is fairly positive. There is unlikely to be any swift moves up given the markets caution towards the sector, but I reckon its possible there could be stepping up throughout the 20's.

Having already covered CapDrill's operations in the first review, I'll start in a different position. As I outlined in the original review, a fair amount of CapDrill's revenues are derived from Centamin Egypt's mining operations at Sukari, in Egypt. The mine has had numerous issues earlier in the year, but some comments from Centamin Egypt that have been released over the past few months are encouraging. In Centamin's Half year report, the company noted that they had reached a new milestone of 'Record gold production 93,624 ounces, up 8% quarter-on-quarter and 39% on the prior year period.' Also within the report, the company noted that the full year guidance of 320,000 ounces remained unchanged. However, that didn't last very long with Centamin's CEO going on to say this in October: “The third quarter saw another strong performance on several fronts most notably a further increase in both tonnes mined from underground and total process plant throughput. Whilst we expect some impact in Q4 on plant throughput from the commencement of Stage 4 commissioning activities, we are now well placed to exceed our initial full year 2013 guidance of 320,000 ounces, provided on 14 March 2013.”

CAPD vs. CEY: Share price action

That is likely to have a positive effect on CapDrill and will probably have helped during Q3. Many holders will recall that in the past, CapDrill's share price has followed Centamin's to an extent. Any sharp spikes in Centamin were mirrored and any general trends, matched. Therefore, it has been disappointing to see that the relationship has detached, not in terms of operations, but only in terms of the respective charts. This is shown on the right. Initially you may think that actually, CAPD is above CEY hence it has outperformed. However, you need to look at the axes. CapDrill is up approximately 25% from its lows. That compares to Centamin being up around 67% from its lows. That is a huge disparity and is probably due to CapDrill suffering elsewhere in the sector. Nonetheless, investors would hope that disparity closes considering how harshly CapDrill was treated when Centamin was in a poor state. Whether that will close is unclear, but Centamin looks strong technically so it could yet be possible for CapDrill to be 'dragged higher'.

Of course though, CapDrill is not reliant on just one mining company - they provide drilling rigs and services to a whole range. Therefore the state of the mining sector as a whole is central to the company's performance. The mining sector has been through an extremely rough patch for a number of months now, and that had meant many mining companies are finding it difficult to raise cash and are stripping back operations and deferring future plans. That is obviously having a considerable impact on CapDrill, which I will get to later. I expect that is what has held CapDrill from matching Centamin's path. The weak mining sector has been mostly caused by weak metal prices as growth in China has slowed and those effects predominantly have been affecting the industry since Q2 2012. Some miners have started making headway in terms of share prices though, and I am fairly bullish on the gold price. It's worth looking at a couple of big names (directly involved with the industry) are saying in order to glean how they see the future:

Caterpillar: "Despite higher mine production around the world, new orders for mining equipment remain very low. As a result, the company is holding its outlook for 2014 sales and revenues flat with 2013 in a plus or minus 5 percent range.We're not seeing bright spots in mining yet, but the turnaround will happen at some point, and when it does, we'll be ready to respond."

Sandvik: "During the third quarter, investments in equipment and systems by mining companies remained low. While cancellations of previously booked orders were negligible, the frequent nature of deferrals and delays was unchanged. This pattern was notable in all major markets for Sandvik Mining. Although the sharp slowdown in the mining industry has affected customer investment decisions, mine production rates have been largely maintained. Consequently, demand for rock tools, services and spare parts remained relatively unchanged."

I'll refer back to these later on. However, at this point in time I want to touch upon a couple of contract wins that CapDrill secured in October. The first of these is with AngloGold Ashanti and it is the largest contract that CapDrill has secured. The contract spans 5 years and refers to services to their Geita gold mine in Tanzania. 5 of the 9 rigs required will be purchased. The contract becomes active at the start of 2014 after being won in a competitive tender process - that underscores CapDrill's expertise in the industry. It should also generate substantial revenues for the group going forward. The second, smaller contract is for rigs to Papua New Guinea and the Solomon Islands. Activity there is forecast to start in late 2013.

Jamie Boyton commented: "These new contracts demonstrate the importance of our focus on organic growth within our blue chip client base, having one of the youngest fleets in the Industry and operating on long life, robust mining projects.The Geita contract is particularly significant for the Group as it adds to our operations in Tanzania and now positions Capital Drilling as the largest drilling contractor in the country. These key contracts provide significant revenues over the next few years and with our ability to provide all of the key drilling disciplines Capital Drilling remains well positioned and is set for any recovery in the mining sector."However, it is the financials that I really want to focus on. I have collaborated the key metrics from the August half year and October Q3 results as shown.

From the above figures it's clear to see that Capital Drilling has been significantly worse affected as the year has gone on, with declines in fleet utilisation, ARPOR and Revenues. However, as you can see, the company's net debt/equity ratio fell and the reason for that is that even at the figures shown, the company is generating free cash flow which is allowing them to pay off their debts. Their debt as at the end of H1 stood at $21.7m vs. $6.7m in cash meaning the net debt amounted to $15.0m. By no means is that a small figure. Equity at the end of H1 amounted to $96.0m. Holding the equity level at $96m as an assumption, would mean that at 12.7%, net debt would have fallen to $12.19m. Some of that probably would have come out of the cash balance, and the rest out of the cash flows.

Q3 2013 has been one of the company's worst ever quarters - there is no escaping that fact. However, the fact that they are still generating Free cash flows in this period of extreme difficulty, is most reassuring. It's a sign of sound management, and a strong business model. This has been significantly aided by a cost-cutting program that should also mean CapDrill is better placed after the downturn. "The strengthening of the balance sheet and improved cash flows from our assets not only ensures that the business has the flexibility to manage significant volatility but also allows Capital Drilling to capitalise on any improved sentiment towards the mining industry in 2014."

Most importantly though is that these results were as expected, with management noting that full year results would be in line with market expectations. Furthermore, Q4 2013 is expected to show a small improvement in revenue which should not be too difficult to achieve. After that, I would expect revenues to pick back up in the new year, as the major contracts kick in. Therefore I have a sense that this is their medium term operational low point. The fact that the market bought into the early decline suggests the consensus is the same.

"Capital Drilling has felt the impact of the global slowdown in mining, impacting capex particularly in drilling, resulting in a significant fall in revenue over the period and utilisation rates of 46%, the lowest in the Company's history. The management team has remained highly focused on continued cost and capital expenditure discipline and, despite the weaker revenue and resulting profit performance, the business has continued to generate positive operating cash flows for the period.

We are encouraged by recent contract wins, most significantly the 4 October announcement of a 5 year comprehensive drilling contract for the Geita Gold mine in Tanzania (AngloGold Ashanti). The contract represents the largest single contract award for Capital Drilling and further underpins our position in the key Tanzanian market, while adding to the Group's exposure to the longer term production drilling market that we have been strategically targeting".

There is one point to draw upon in this quote, and that is the focus on longer term production drilling. As in the Sandvik quote, the production mining sub-sector has actually continued to be fairly stable amidst the exploration led downturn. That is largely due to production levels at the most robust mines being kept intact. A move to diversify away from the exploration side makes commercial sense, and if implemented correctly, I expect that to also have a major impact on CapDrill in the long term. They would be better at negating these downturns and that ultimately inspires confidence. The following quote is also reassuring: "Global conditions for the Mining industry showing initial signs of stabilisation." and that tallies with Caterpillar's thoughts. As a point of interest, the table below is a quick comparison of revenue trends over the past two halves, for competitors in the same general sector to CapDrill.

Capital Drilling has weathered the storm fairly well compared to some of the smaller companies. There is a general trend that the larger the company, the less the impact. However, the negative impacts can take time to filter through, as is the case for CAPD with Q3 being particularly harsh and Q4 only forecast to be slightly better

In my opinion, as I noted earlier, Capital Drilling offers investors a different route to access the mining market and benefit from any future upside, without incurring the same risks that most small cap miners hold, such as cash and legislation. The company has an excellent client base thus is fairly well protected from any specific company issues (although the Centamin debacle is of concern). Once again I come back to the point - if Capital Drilling can still make headway even with the significant industry headwinds, then the future is bright once the industry turns around. Such is the nature of the clients that revenues are unlikely to continue to fall - large cap miners tend to keep the same levels of mining at their production assets and shelve the riskier exploration ones. In that respect, they have a steady foothold. The management decisions here that have allowed them to remain generating free cash flow is impressive, and thus I would continue to back the board in stabilising the company. It is likely that the mining environment will remain subdued heading into 2014, but with the debt pile already declining and important strategic decisions being made, I'd back CapDrill to emerge as a more robust outfit. As Caterpillar noted, the mining industry will turn - it's not really a case of if. When it will turn is unclear, but given a brightening economic outlook and the Chinese government's declaration to back the growth story, it's worth having sensible exposure. A medium/long term opportunity. I have put a 'Buy' tag on the company at 19.88p.

UPDATE (21/11/13): I have moved Capital Drilling from Buy to No Rating at 27.25p after the company has enjoyed a strong run from sub 20p levels. The result is a 37% profit. The rise has been faster than I expected hence it could stabilise at slightly lower levels. Take profits for the time being

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